Using home equity wisley: Debt consolidation to avoid payment shock on a new home
Do you want to buy a new house, but don't want to give up your low interest rate, or don't think you can afford the home of your dreams at today's current rates?
If you have other debt (for example, credit cards and car loans), you might be surprised to find out that current mortgage rates are lower than your "blended" rate. A blended rate is determined when you combine all your debts and their associated interest rates to create the net average rate. So while your home's rate is nice and low, your credit cards are often high.
Most people purchasing a new home want to use all of the equity in their current home as a down payment on their new purchase. BUT, this may not be the most financially beneficial approach. Instead, if you use part of the equity in your home to pay off a large portion of your debt, you could purchase your dream home now, have fewer monthly obligations, and minimal payment shock.
This example shows the blended rate of 6.621% for someone with a first mortgage (Loan 1), 4 credit cards (Loans 2-5) and an installment loan (Loan 6).
This client purchased a home 4 years ago for $500,000, has a loan of $400,000 at 3.750%, currently owes $370,000, and will sell the home for $660,000. As a result they have $290,000 in equity.
This client wants to buy a new home for $750,000. If they use all the proceeds from their sale, they will have a $500,000 mortgage with 6.5% interest. Including payments for all six of their loans, their total monthly payments will increase $1,825. Yikes!
However, if they use a portion of the proceeds to pay off the 4 credit cards and they have a slightly higher mortgage of $556,000 with 6.5% interest, their total monthly payments only increase $179 because they no longer have those high interest payments on their credit cards. That's not so bad!